Since 1989, the fabless EZChip ( EZCH) (formerly LanOptics, Inc.) has designed and sold unique “chips” for use in telecom networks, data centers, and enterprise backbones. Their chips accelerate the transmission of the “triple play” (e.g., data, voice and video). They use Carrier Ethernet technology that offers the cheapest and most efficient method of increasing the capacity of stressed legacy networks.

EZCH offers programmable merchant Net Processing Units (NPUs) with a full range from the slowest to the fastest chips.The fastest chips are used for 6 to 8 years and the slower chips (less expensive and higher volume) are used for 2 to 3 years. At this time, EZchip’s major competition comes from in-house designed ASIC chips that are extremely expensive to design and test. Most importantly, EZCH competes by introducing new, interchangeable chips with additional features on a three year cycle. New chips can replace existing EZCH NPUs without expensive system upgrades.

EZCH has generated most of its income from chips in the Carrier Ethernet Switches and Routers (CESR) market where five of the largest six Tier-1 carrier networking equipment vendors are their customers.

Cisco ( CSCO) has about 50% of the CESR market and is increasing its purchases of EZCH chips through a royalty arrangement with Marvell ( MRVL). Juniper ( JNPR), with about 20% of the market, used to be EZCH’s largest customer. Orders are now declining because their new products use in-house chips. Ericsson ( ERIC), Huawei, Tellabs ( TLAB), and ZTE are becoming larger EZCH customers.

In 2010, EZCH initiated sales of lower speed processors (NPAs). These chips are cheaper and less sophisticated but sell in higher volume. Fourteen vendors operate in this space, of which eleven are historically EZCH customers. Two positive selling points are:

EZCH now offers a full component of programmable and interchangeable chips.Customers are incorporating faster NPUs in slower chip applications. Market Size

Internet traffic is growing at a tremendous pace because of the dramatic increase of video traffic. Infonetics Research projects that the Carrier Ethernet equipment market size will grow from $27.5 billion in 2010 to $40.5 billion in 2015. The existing legacy networks can only keep pace with the traffic growth by utilizing Carrier Ethernet technology.

From 2010 to 2015, EZCH estimates that their Merchant NPU and NPA market (as opposed to the ASIC market) will grow from $397 million to $800 million, and the NPU market (high speed) alone will grow from $116 million to $450 million.

In 2010, EZCH sold over 53% ($62 million) of the Merchant High Speed NPUs. EZCH is in position to increase sales significantly for the following reasons:

EZCH now sells both NPA and NPU chipsNPU market, EZCH’s strength, is growing faster than the NPA market.Cisco, much larger than Juniper, will become EZCH’s largest customer. Financial Results (USD Non-GAAP Numbers)

EZchip is located in Yokneam, Israel and is incorporated under the laws of Israel. Financial statements are prepared in U.S. Dollars and conform to U.S. GAAP accounting principles. EZchip shares are traded on the NASDAQ Global Market and on the Tel-Aviv Stock Exchange under the symbol EZCH.

3rd quarter 2011 – Non GAAP

3rd quarter, 2011

2nd quarter, 2011

3rd quarter, 2010

Total

Revenue

$18.7million

$17.3 million (+8%)

$16.4 million (14%)

Net Income

$ 9.9 million

$ 9.4 million (+6%)

$ 8.7 million (+14%)

Gross Margin

76.3%

80.0%

76.9%

Net Margin

53.4%

54.2%

53.1%

EZCH cash, cash equivalents and marketable securities increased $6.6 million from the second quarter, 2011 to $127.6 million in the third quarter.

Product Detail

(Note: Marvell pays royalties to EZCH for chips they provide to Cisco. Revenue to EZCH is delayed for 30 days.)

In 2011, EZCH generated most of its revenue from NP-2 and NP-3 sales.NP-4 will go into production this month, and Tier 1customers will install the chips starting in the 1st quarter of 2012.

The NP-4 is a big deal. The NP-4 has won twice the NP-2 and NP-3 platforms and operates at twice the speed. Five of the seven major CESR vendors have tested and will use the NP-4. According to the company, EZCH “expects the NP-4 revenues to be four times NP-2 and NP-3 …”

The NPAs are not as profitable as NPUs. EZCH offered its first NPAs in December, 2010. They are used mostly in the access market. The NPAs sell in higher volume, but are less sophisticated. Infonetics estimates that the merchant NPA market will grow from $281 million in 2010 to $350 million in 2015.

To EZCH’s advantage, NPUs are transitioning to the traditional NPA areas. In addition, EZCH’s participation with NPAs is starting to offer new opportunities. One EZCH partner is using technology from the NPA-0 to develop a chip that could eventually generate royalties of a few million dollars.

The NP-5 is a bigger deal. The NP-5 should sample in 2012-13 and be produced in 2014. However, customers want the NP-5 as soon as possible because it integrates additional functionality and will be much faster. EZCH said, “It’s highly likely that all of our NP-4 customers will move to NP-5 with us.”

Mystery product being developed in Kiryat Gat, Israel. EZCH is developing a top secret product in conjunction with specific customers. They hope to announce details in 2012.All the company will say is,

We are making a lot of progress. The customers like it a lot. We believe it’s going to be a paradigm shift in how products of that nature are being built. I think that we will be very successful. Both the NP-5 and Kiryat Gat products are expected to generate growth when the NP-4 reaches its peak revenues.

We feel comfortable about Cisco’s success, especially with the ASR 9000, and believe that we are very early in Cisco’s ramp up as a customer and believe it can accelerate once Cisco moves its NP-4 based systems into production.

As we move forward, Juniper will become a smaller customer for us because they are moving from the NP-2 to in-house chips.” Revenues from Juniper could decline about 40% in 2011 from 2010. Juniper revenue next year (2012) will be lower than this year. We simply don’t know … how quickly they will move from us to their in-house chip.

ZTE: 29% of EZCH 3rd quarter, 2011 Revenues (New 10%+ customer)

3rd quarter, 2011

2nd quarter, 2011

3rd quarter, 2010

$3.9 million

$ 2.2million

$1.8 million

EZCH said, “We are pleased with ZTE’s revenue growth and believe it can accelerate once ZTE moves its NP-4 based systems to production.”

Note: ZTE sells to large carriers that make large project purchases. Revenue will be lumpy.

Other Customers: (Excluding Cisco, Juniper and ZTE)

31% of EZCH 3rd quarter, 2011 Revenues

3rd quarter, 2011

2nd quarter, 2011

3rd quarter, 2010

$5.7 million

$ 6.4 million

$3.5 million

Three of these customers are now close to production with important NP-4 based platforms. These customers could become 10% customers and improve EZCH’s customer concentration.

Customer Margins

Cisco (Through Marvel) estimates gross margin at 90%. (Royalties)Direct Customers estimate gross margin of 70%EZCH estimates that the average gross margin for all customers in 2012 will be about 78%Guidance

Fly In the Ointment– In conference calls, EZCH has expressed that it has traditionally experienced lumpiness in quarterly revenues, especially from large customers as a result of inventory changes by the contract manufactures. EZCH cannot anticipate these sudden inventory adjustments because they do not deal with the ultimate buyer.

According to the company:

We expect fluctuations like that. We manage our business long-term. We look at trends. We look at the market. We look to where the market is going. We look at the growth rate and that’s how we manage our business. There is not much we can do about fluctuations in each quarter. Annual revenue comparisons are a more accurate measure.

EZCH projects a 25 to 30% decline in revenues from 3rd to 4th quarter, 2011 because of inventory adjustments caused by global economic uncertainty. According to the company: “We are well positioned to see growth as economic confidence is restored and spending resumes to previous patterns.”

2011: A transition year

EXCH said that 2011 is a transition year for the following reasons:Cisco with over 50% of the CESR market is becoming their largest customer and Juniper with about 20% of the market is incorporating in-house chips. All other customers, except Juniper will grow significantly in 2011 (and 2012) over 2010Most revenue in 2011 was earned from NP-2 and NP-3 chips.The NP-4 will be in production in 2012 and is “expected to generate very significant production revenues …”Infonetics Research projects that NPUs are “expected to experience further accelerated growth.”EZCH customer inventories are being reduced significantly. When demand picks up, EZCH will pick up stronger. EZCH expects total revenues in 2011 to approximate the $62 million that was generated in 2010. Operating expenses are expected to be lowered to $20MM from $22MM in 2010 because of the lower US dollar.

Research Expenses ( NRE) paid to the Israeli Government were lower in the 3rd quarter, but are expected to grow with the increase in NP-4 sales.

Annual gross margin is expected to be about 78%. Fourth quarter gross margins should be in the lower 75% range because of the product mix and because fixed expenses must be spread over lower total revenue.

EZCH reported $1.14 per share (diluted) Non-GAAP net income for 2010.

EZCH estimates gross revenue for 2011 at about $62 million. I estimate 2011 net income per share (diluted) of $1.10 to $1.15.

Looking ahead to 2012

EZCH says they have limited visibility because NP-4 is initiating production in the 4th quarter, 2011. Revenues in 2012 will depend on the spending of tier 1 carriers. Hopefully, economic conditions will encourage those carriers to spend money by the first quarter of 2012. Therefore, EZCH can hope, but cannot project, a recovery by the first quarter of 2012. They do see accelerated growth in the coming years.

EZCH expects operating expenses to increase to from $20 million in 2011 to $25 - 27 million in 2012 because of higher expenses for research and new employees.

Also, EZCH said that revenue in 2012 should be higher than in 2011 because the NP-4 has won “twice the number of platforms … and the margins are higher so we expect the NP-4 revenues to be four times NP-2 and NP-3 combined. The NP-4 will be very significant in our revenues.”

What can go wrong? Among other issues:

EZCH is an Israeli company. Even though EZCH has back up administrative and research facilities in the US, the stock is vulnerable to any Mideast conflict.The NP-4 is just going into production. The chips have been tested and approved through a long arduous process; however, production problems can always developThe US and World economy can remain under stress and cause EZCH’s order flow to remain uncertain.New technology could be developed that will compete with EZCH products. Why Buy EZH Now?

EZCH is trading at about 27 times 2010 and 2011 earnings. The multiple can be much higher with higher earnings.EZCH sells in a rapid growth industry.EZCH has an accepted product quality – with a strong order flow.EZCH released a roadmap of products until the year 2015.EZCH demonstrated revenue and earnings growth.EZCH earns a high gross margin estimated at 75% for 2011.EZCH projects a gross margin of 78% for 2012.Net Income has been running at about 53% of revenue.EZCH has cash of $127.6MM with no debt.EZCH outsources all production with royalty payments from Marvell. Revenue (millions)

Net Income (millions)

2007

19,488

394

2008

33,566

6,820

2009

40,046

14,019

2010

62,000

30,397

2011

62,000 (Est.)

30,000 (Est.)

I believe that the inventory adjustments in the fourth quarter, 2011 give investors an opportunity to buy EZCH at prices that will be extremely attractive within the next year. Each investor, depending on his/her risk profile, should own some EZCH shares to hold for when the earnings from MP-4 start to build and EZCH has a high probability of trading at much higher multiples. If the NP-5 is as successful as projected and other new products are developed, the stock could trade at extremely high prices in years going forward.

Note: A new rumor has just surfaced that Marvell will buy an EZCH competitor, the private company, Xelerated Inc. Even if the rumor is true, I do not believe this will affect the success pattern of EZCH.